Updated for the 2026 CFA® Level I curriculum.
Private debt is lending that happens outside public bond markets. A lender and a borrower negotiate the terms directly, so the loan fits the borrower's situation instead of following a standard bond structure. CFA Level I tests whether you can connect a loan's contractual terms and capital-structure position to its risk and return. Expect a fact pattern describing a loan's seniority, collateral, covenants, and rate structure, then a question asking what that combination means for the lender.
Quick Answer
What is private debt? It is a loan or debt security negotiated privately between a borrower and a lender, rather than issued and traded in public markets.
Main categories include direct lending, mezzanine or subordinated debt, and distressed debt or special situations. Investors earn returns from interest, fees, and recovery value. Seniority, collateral, and covenants protect the lender, but default risk and illiquidity remain central concerns for any private debt investment.
Key Takeaways
Private debt is non-publicly traded lending negotiated directly between borrower and lender.
Main categories are direct lending, mezzanine or subordinated debt, and distressed debt or special situations.
Returns come from contractual interest, origination fees, and recovery value after default.
Seniority and collateral determine how much a lender recovers if the borrower defaults.
Covenants are negotiated terms that protect the lender but do not eliminate loss risk.
Floating-rate loans reduce interest rate exposure but increase borrower stress when rates rise.
Credit risk, illiquidity, valuation uncertainty, and concentration are the core risks in private debt.
What You Need to Know for CFA Level I
Define private debt as non-publicly traded lending negotiated between borrower and lender.
Identify direct lending, mezzanine or subordinated debt, and distressed debt or special situations.
Explain how interest, fees, and recovery value generate returns for private debt investors.
Interpret seniority, collateral, covenants, and floating-rate terms as lender protections.
Explain default, liquidity, valuation, concentration, and economic-cycle risks in private debt.
Compare private debt with public debt only to highlight defining features, not to test bond mechanics.
What Is Private Debt?
Private debt is a loan or debt security that is not broadly traded in public markets. Instead of issuing a bond that trades on an exchange, the borrower negotiates terms directly with one lender or a small group of lenders. This negotiation lets the parties customize maturity, interest rate, collateral, and covenants to fit the borrower's specific needs.
This customization is the defining feature of the asset class. A public bond investor accepts standardized terms set at issuance. A private debt lender negotiates terms that fit one borrower, which can improve protection but reduces the ability to compare the loan to other investments or sell it quickly.
Feature | Public Debt | Private Debt |
|---|---|---|
Trading | Trades on public markets | Not broadly traded |
Terms | Standardized at issuance | Negotiated for one borrower |
Pricing | Continuous market pricing | Periodic or model-based valuation |
Liquidity | Generally higher | Generally lower |
Types of Private Debt
Private debt covers several exposures. Each type sits at a different point in the borrower's capital structure, and that position drives loss severity if the borrower defaults.
Senior direct lending places the lender at the top of the repayment line, often secured by collateral. This is the lowest-risk category within private debt.
Unitranche debt blends senior and subordinated terms into a single loan with one blended interest rate. It simplifies the borrower's financing but mixes risk levels that would otherwise be separated.
Mezzanine or subordinated debt ranks below senior debt in repayment priority. It carries higher risk and typically pays a higher coupon.
Distressed debt and special situations involve borrowers already in or near financial trouble. Lenders here accept high uncertainty in exchange for potential recovery gains if the borrower's situation improves.
Type | Capital-Structure Position | Relative Risk |
|---|---|---|
Senior direct lending | Top priority, often secured | Lower |
Unitranche | Blended senior/subordinated | Moderate |
Mezzanine/subordinated | Below senior debt | Higher |
Distressed/special situations | Varies, often impaired | Highest |
Private Debt Return Sources and Lender Protections
Private debt returns come from three sources. Interest income, which can be fixed or floating, forms the base return. Fees, including origination fees charged at loan issuance, add to total return. Recovery value, the amount collected if the borrower defaults, determines the final outcome when things go wrong.
Lender protections shape how much risk the interest rate needs to compensate for. Collateral gives the lender a claim on specific assets. Seniority determines the lender's place in the repayment line. Covenants are negotiated terms, such as limits on additional borrowing, that give the lender early warning or control if the borrower's financial condition weakens.
Term | Effect on Investor |
|---|---|
Floating rate | Reduces interest rate risk, raises borrower payment risk when rates increase |
Collateral | Improves recovery if borrower defaults |
Seniority | Determines repayment order relative to other lenders |
Covenants | Provide early warning or control, not a guarantee against loss |
A higher contractual yield generally compensates the lender for greater credit risk, illiquidity, or structural complexity. It is not a bonus with no offsetting risk.
Private Debt Risks and Investment Characteristics
Private debt carries several risks that a public bond investor may not face in the same way.
Default and downgrade risk exists because private borrowers often have less established credit histories or weaker access to public financing.
Illiquidity and valuation uncertainty result from the lack of a public trading market. Investors often rely on periodic, model-based valuations rather than market prices.
Economic sensitivity and refinancing risk rise during downturns, when borrowers may struggle to meet payments or refinance maturing debt.
Concentration and manager underwriting risk matter because private debt funds often hold fewer, larger positions than public bond portfolios. Manager skill in selecting and structuring loans has a large effect on outcomes.
Floating-rate exposure cuts both ways. It reduces the lender's interest rate risk, but it increases the borrower's debt-service burden when rates rise, which can raise default risk on the same loan.
Risk Source | Transmission | Possible Mitigant |
|---|---|---|
Weak borrower credit | Higher default probability | Stronger covenants, collateral |
No public market | Valuation and exit uncertainty | Manager due diligence, hold-to-maturity approach |
Economic downturn | Refinancing and repayment stress | Seniority, floating structure with caps |
Rising rates | Higher borrower payments | Covenant monitoring |
Worked Example
Meridian Fund lends to Harbor Industrial, a mid-sized manufacturer, through two separate private debt investments.
The first loan is a senior secured direct loan. It is collateralized by Harbor's equipment and carries a floating rate of SOFR plus 4%. Meridian sits at the top of Harbor's capital structure for this claim.
The second loan is a mezzanine loan to the same borrower. It is unsecured, ranks below the senior loan, and carries a floating rate of SOFR plus 9%.
Both loans reference the same borrower and the same floating-rate benchmark. The senior loan has a lower coupon because collateral and top priority reduce loss severity if Harbor defaults. The mezzanine loan's higher coupon compensates Meridian for standing behind the senior lender and holding no collateral claim. If Harbor defaults, the senior loan likely recovers more of its principal. The mezzanine loan faces a higher chance of partial or full loss.
This shows that capital-structure position and contract terms change risk and expected return even when the underlying borrower is identical.
Common Exam Traps
Confusing private debt with private equity. Private debt is a lending claim with contractual interest and repayment. Private equity is an ownership claim with no fixed repayment schedule.
Assuming a floating rate removes credit risk. A floating rate adjusts for interest rate changes. It does not protect against the borrower's inability to pay.
Ignoring seniority and collateral. Two loans to the same borrower can have very different loss severities based on capital-structure position alone.
Treating a high coupon as a free return advantage. A higher coupon usually compensates for weaker priority, less collateral, or greater borrower risk.
Assuming private loans are easily traded. Private debt generally lacks a public secondary market, which limits an investor's ability to exit quickly.
Equating covenants with a guarantee against loss. Covenants give the lender warning signs or control rights. They do not guarantee full repayment.
Practice Question
An investor is evaluating a loan to a cyclical manufacturing company. The loan is subordinated, unsecured, and pays a floating rate of SOFR plus 8%, well above the rate on the company's senior secured debt.
Which statement best describes the investment characteristics of this loan?
The floating-rate structure eliminates the loan's credit risk during economic downturns.
The high coupon compensates the lender for subordination, lack of collateral, and the borrower's cyclical exposure.
Because the loan is privately negotiated, it carries less risk than a comparable publicly traded bond.
Correct Answer: B
The loan's subordinated, unsecured position means the lender recovers less than senior secured lenders if the borrower defaults. Cyclical exposure raises the chance of financial stress during downturns. The elevated coupon reflects compensation for these combined risks, not a risk-free premium.
Option A. A floating rate adjusts the interest payment for rate changes. It has no effect on the borrower's ability to repay principal, so it does not eliminate credit risk.
Option C. Private negotiation does not automatically reduce risk. Subordination and lack of collateral increase loss severity regardless of how the loan was originated.
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FAQs About Private Debt
What is private debt?
Private debt is a loan or debt security negotiated directly between a borrower and a lender, rather than issued or traded on public markets. Terms such as maturity, rate, and collateral are customized to the borrower, which can improve lender protection but reduces liquidity and market comparability.
What are the main types of private debt?
The main categories are senior direct lending, unitranche debt, mezzanine or subordinated debt, and distressed debt or special situations. Each occupies a different position in the borrower's capital structure, which affects loss severity and required return.
How does private debt differ from public debt?
Public debt trades on established markets with standardized terms and continuous pricing. Private debt is negotiated for a single borrower, valued periodically rather than continuously, and generally far less liquid than a comparable public bond.